Question

Suppose that you are a hedger. That is, you (or your business) is exposed to some type of financial risk. Using some hypothetical numbers and examples of your own, explain how you can use puts (or calls) as hedging tools to protect you from the risk. Assume 3% of your option’s exercise price as transaction costs. (5 points)

Answer 1

A hedging is process wherien you use put or call options or / and futures contract to protect from losses if the market volatility goes against you .

Eg : Use of futures contracts

Say you have bought stock A for 10 $, Now it a week it goes to 20$. Now you are in the view that these prices are high and might further fall down . You dont want to sell the stock but need protection from the downfall.

In this case you will buy a put option for the said stock by paying a certain premium for a certain strike price . .

In this case we will assumr Strike price ( Exercise price ) 20$ and premium of 1 $. In the case the stock goes down from 20 $ to say 5 $ ( Assuming its and American put option ).The net outcome of the trade will be as follows

1) Loss in cash market on the stock = Purchase price- Current price = 10-5 = -5$

2) Profit from Put option = Exercise price- current market price = 20-5- cost of transactions ( .60$)= 14.40 $

Profit = 9.40$. This is a hypothetical assumption. Put helps in protecting from downside risk . Premium paid for the put will be lost in case the stock prices rise as the put will expire worthless